The Arizona Supreme Court refused to hear the appeal of ADP, LLC v. Arizona Department of Revenue,1 leaving in place a lower court decision that broadly applied the state’s transaction privilege tax (TPT) to digital services. The court issued its order on September 12, 2023.
The case involved ADP’s eTime software. Under a human resource services contract with Maricopa County, ADP granted county employees access to eTime so that employees could log in to eTime to enter their time and employment information. ADP then used this information to generate paychecks for the employer. All eTime software code and servers were located outside of Arizona. The Arizona Department of Revenue (ADOR) and the city of Phoenix assessed and collected TPT from ADP on revenue generated by the contract with Maricopa County. ADP filed refund claims with both entities, which were denied. Appeals to Superior Court were likewise denied.
In a decision issued earlier this year, the Arizona Court of Appeals determined that the eTime software is a form of tangible personal property (TPP) and that ADP’s arrangement with the county constituted a taxable lease of TPP under A.R.S. § 42-5071(A). For TPT purposes, Arizona broadly defines “tangible personal property” to mean “personal property that may be seen, weighed, measured, felt or touched or that is in any other manner perceptible to the senses.” See A.R.S. § 42-5001(21). Although the definition does not expressly include software or digital goods or services, the appellate court relied on a 1943 Arizona Supreme Court decision, State v. Jones,2 to find that eTime is a form of TPP. In Jones, the court found that revenue from a jukebox was subject to TPT because “the playing of the record is perceptible to the sense of hearing and, hence, constitutes what the statute terms tangible personal property.” Applying the same reasoning, the court in ADP said that eTime is perceptible because it can be viewed by the users while accessing and using the software. Although ADP argued that computers are very different than jukeboxes, the court responded that the mechanism was not the determining factor, but rather the perceptibility of what was being purchased.
ADP additionally argued that they provided a service that is the primary object of the transaction, and the property is incidental to, or an inconsequential element of, service and not separately charged. This argument is one of the three approaches used by the Court to draw the line between taxable TPP and nontaxable services. However, the Court maintained that ADP’s invoice showed separate charges for Hosting Services, ADP Enterprise eTime, Hardware Shipping and Handling, and Implementation Charges. The Court determined that separate charges for eTime distinguished it from true services charged under the contract.
The Court rejected ADP’s argument that subjecting eTime to the TPT would violate the Internet Tax Freedom Act (ITFA), which prohibits “multiple or discriminatory taxes on electronic commerce.” ADP argued that imposing the TPT violates the ITFA because the ADOR “treat[s] ADP’s online paycheck services differently than it would services involving physical assets, the way ADP conducted business pre-internet.” The Court responded that the change in taxation is because of the automation of ADP’s work, not the use of the internet.
This is a very important decision in that taxpayers need to be concerned that software as a service (SaaS) could now be taxed as the sale of TPP. If you are concerned that this approach may impact your business, please call one of the Ryan experts listed below.
1 Arizona Court of Appeals, No. 1 CA-TX 21-009 (January 31, 2023).
2 60 Ariz. 412 (1943).
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